Penny stocks often get attention for one simple reason: the possibility of huge gains with the infusion of a small capital. When the market is on an upward trajectory, these kinds of stories tend to spread pretty fast. But beneath all the hype and excitement, the risks are there as well.
Before you think of parking your money, you really need to approach penny stocks with a clear head, a bit of caution and a solid understanding of what you are getting yourself into. Here are five crucial steps that can help you avoid some of the common pitfalls and make better decisions.
1. Understand the Business, Not Just the Price
The low price of a stock can be misleading. It is a trap that many people fall into. No matter how low the price is, if the underlying business is fundamentally weak, then it is no use thinking about it.
Before investing, take some time to really understand what the company actually does. Look at their revenue streams, product relevance, where do they stand in their industry and what is their operational history been like?
2. Check Liquidity and Trading Activity
Liquidity is a big deal when it comes to penny stock investing. Stocks with poor trading volume can trap investors, thus making it difficult to exit positions at desired prices. Before you start, take a look at the average daily trading volume and see how the price is moving.
While some investors track highest volume stocks to identify active stocks, volume alone doesn’t tell the whole story. You see a big spike in trading, and at first glance, it might look like a good sign, but more often it is due to short-term speculation.
3. Review Financial Statements Carefully
Financial transparency is often limited in this segment. You need to take a close look at the big picture and pay close attention to things like:
- Revenue
- Profitability
- Debt levels
- Cash flow
If all you are left with is a bunch of questions and no clear answers, then it is probably best to take a step back and say, “I am not sure about this one”.
4. Be Aware of Volatility and Price Manipulation
Penny stocks are known for their wild price swings. Just a tiny shift in investor demand can send the price careening out of control, often without any real reason to do so.
This volatility makes penny stocks easy pickings for price manipulators, who use coordinated buying and selling to temporarily inflate prices. But when the hype dies down, the price usually crashes, leaving late entrants exposed to losses.
5. Define Clear Risk Limits Before Investing
Managing risk is non-negotiable when dealing with penny stocks. Before you even start pumping money into these high-risk investments, decide how much you are really prepared to lose.
Think about this: What is a fair price to lose on a particular stock? How big a position can you afford to take on without blowing your whole account? And most importantly, where is your stop-loss level, given the crazy price swings these stocks are known for?
The thing is, penny stocks should never form the core of your portfolio. They can’t be trusted to provide steady returns, and they are far too volatile to be relied on. At best, they can form a tiny portion of a well-diversified investment portfolio.
Who Should Consider Penny Stocks?
Penny stocks might be a fit for investors who:
- Have a high risk tolerance
- Understand market cycles and volatility
- Are okay with the possibility of losing some or all of their money
- They are only using spare cash they can afford to lose
Final Thoughts
Penny stocks can be quite tempting, but the truth is they need a whole lot of discipline, not to mention patience and careful research. The risks are way higher with penny stocks than with established companies.
You can invest in penny stocks by concentrating on the business fundamentals, making sure of liquidity, keeping an eye on a company’s financial health and being clear about your risk limits.
